Policy Issues

To manage persistently large capital inflows, policymakers in the region must address the following questions:

• Of the measures tried before, which work better and why?
• What other domestic policy options should be mobilized?
• Is there a scope for collective action, particularly at the regional level?

This section discusses possible policy measures to manage surges in capital inflows.

Summary of Policy Measures [ PDF 40.7KB | 4 pages ]

Doing More of What Has Been Tried Before

Sterilized intervention. Sterilization has been the favorite tool applied by many emerging Asian economies to prevent nominal and real exchange rate appreciation and economic overheating. Because net foreign exchange inflows from the current and capital accounts have been sustained for quite some time now, intervention in the foreign exchange market has been unidirectional, making sterilization an increasingly costly method of preventing overheating of the economy.⁴ The need to allow greater exchange rate flexibility is thus becoming more compelling. Making this an attractive policy option for the region's authorities is an important challenge that is explored below.

As of end-2007, total foreign exchange reserves in the world were more than US$5 trillion with the emerging Asian economies accounting for half of it. However, there is a growing consensus—based on standard measures of reserve adequacy, e.g., in terms of months of imports of goods and services, and in terms of ratios (of reserves) relative to external debt, to GDP, or to domestic money supply—that these foreign exchange reserves are excessive. Even though it is difficult to come up with a reliable estimate of the optimal level of reserves, the current total foreign reserves in Asia exceed the level that is needed for mitigating abrupt capital reversals or external financing in crisis. The countries' apparent desire for large reserves may be reduced if there is a credible reserve-sharing arrangement at least at the regional level. Such an arrangement, like an expanded, multilateralized Chiang Mai Initiative, would collectively insure member countries against short-term capital reversals without each member holding unnecessarily large reserves, which is costly.

Strengthening national financial markets. One important lesson learned from the Asian financial crisis and from the recent US subprime crisis is that the banks and other financial institutions must be well governed and their risk management capacity must be high. Thus, there is now great appreciation of the importance of financial-sector supervision and regulation in each country, in inducing banks and non-bank financial institutions to manage large capital inflows in a prudent way. Efforts must be intensified to (i) improve prudential regulations such as limiting the practice of concentrating lending to a few individuals or business entities and moving towards Basel 2 capital adequacy standards, (ii) ensure stronger governance and risk management of financial institutions through greater transparency and better disclosure, and (iii) enhance the capacities of regulatory bodies.

At the same time, reforms to accelerate the development and deepening of domestic capital markets and to put in place efficient market infrastructure must be pursued to enhance the absorptive capacity of domestic financial markets to match large capital inflows. The Asian Bond Markets Initiative (ABMI) is in support of such national efforts. The growth of domestic capital markets would provide alternative channels for intermediating ample domestic savings and foreign funds for domestic investment and would help alleviate the burden put solely on the banking sector.

Controls on capital inflows. Capital controls are a common tool for limiting capital inflows in emerging market economies. While capital controls can take a variety of forms, for countries that have substantially liberalized the capital account, more market-based controls—such as the Chilean unremunerated reserve requirement imposed on capital inflows—have been the predominant option in recent years. Thailand adopted this measure in December 2006, but encountered a severe side effect of rapidly falling stock prices, suggesting that designing and implementing capital inflow control is not an easy task. To these economies, returning to the days of draconian capital controls or recreating a system of extensive administrative controls is no longer a viable option.

Evidence on the effectiveness of capital inflow controls is mixed. Country experiences suggest that the best market-based controls can be expected to do is to lengthen the maturity of inflows; such controls can have little impact on the volume. The effectiveness of capital control measures tends to weaken over time as agents in the markets find ways to circumvent them. At the same time, capital controls can produce adverse effects: they tend to increase domestic financing costs, reduce market discipline, lead to inefficient allocations of financial capital, distort decisionmaking at the firm level, and be difficult and costly to enforce. To the extent that capital controls are effective only for relatively short periods of time, such measures might be used at the time of surges of inflows rather than as a permanent measure (Grenville, 2008). But again, effective implementation is not an easy task. Administering capital controls requires high administrative capacity, as country authorities must constantly look out for unwanted flows—often disguised—entering through other channels.

The story may be different for countries such as the PRC and India, which have not substantially opened their capital accounts and maintain restrictions on some types of capital transactions. In a way, they have been successful in managing the process of gradual capital account liberalization by moving to adopt investor-based controls and prudential-like measures. Capital account liberalization needs to be well-sequenced, proceed within an integrated framework to improve macroeconomic and financial-sector management, and be accompanied by the development of institutions that can ensure markets' continued stability.

Easing restrictions on capital outflows. Countries with significant capital controls have tried easing restrictions on capital outflows in a limited manner to reduce net capital inflows. Easing restrictions on capital outflows is expected to generate some capital outflows, reduce the size of net capital inflows, and hence mitigate the upward pressure on exchange rates. This is the policy that used to be pursued by many East Asian economies, like Japan, Korea, and Taipei,China during the periods of large balance of payments surpluses. It has been adopted by the PRC in recent years.

As these measures are expanded, it must be kept in mind that a more liberal capital outflow policy could invite more capital inflows. Thus, to be effective, these measures need to be combined with other measures mentioned above, such as strengthening financial sector supervision.

Exploring Other Options

The countries in the region can explore other policy options that they have not rigorously pursued in the past in order to contain, mitigate, or cope with the adverse impact of surges in capital inflows.

Fiscal policy tightening. In emerging Asia, fiscal policy has not yet been explored thoroughly as an instrument for managing large capital inflows. Although there is no definitive theoretical presumption on the impact of fiscal policy on capital flows, evidence from country experiences suggests that countries that use fiscal tightening tend to perform better than others in managing the adverse consequences of large capital inflows (Schadler, 2008). Tightening fiscal policy or more generally making the fiscal policy stance countercyclical to surges in capital inflows has often been found to help reduce the risk of an overheating economy and the appreciation pressure on the domestic currency. This lessens the need for the monetary authorities to engage in costly and often ineffective sterilized intervention in the foreign exchange market. Exploring ways to make fiscal policy flexible in the face of surges in capital inflows therefore should receive high priority.

The appropriateness of this policy for emerging Asia must be assessed carefully because in recent years, most economies in the region have been running very slim fiscal deficits, if not fiscal surpluses. Tightening fiscal policy further can be achieved only if governments are willing to forego the provision of some basic services or curtail much needed investment in infrastructure. A realistic option in the face of surges in capital inflows and the associated economic boom would be to exploit the automatic stabilizer function of the budget. That is, the government may implement planned infrastructure investment and basic services delivery without increasing spending out of higher tax revenues or reducing tax rates. This automatic fiscal tightening can offset the impact of the economic boom associated with surges in capital inflows and lead to a better macroeconomic outcome.

Rebalancing growth. In the context of the economies affected by the 1997–98 financial crisis—Indonesia, Korea, Malaysia, Philippines, and Thailand—there is a need to increase private investment, thus refocusing the engine of growth from external demand to domestic demand. Public investment especially in soft and physical infrastructure is a key measure to stimulate domestic demand in the short run.

In the context of the PRC, there is a need to reduce savings. The PRC's investment-GDP ratio is very high and the savings-GDP ratio is even higher. The challenge for the PRC is to reduce corporate and household savings and redirect investment towards soft investment with high social rates of return. One effective way would be for the authorities to absorb a large portion of corporate savings (or undistributed profits) through lower interest subsidies to, and/or collection of larger dividends from, state-owned enterprises and through generally higher taxes on private corporations. The revenues could be spent on social sector protection (such as health, education, pension reform), environmental improvement, energy efficiency, and rural sector development.

Although these measures are not intended to contain or mitigate the adverse impacts of large capital inflows, they are desirable not only in and of themselves, but also in order to reduce the current account surpluses and hence to minimize upward pressure on the exchange rate.

Scope for Collective Action

The broad consensus in the academic literature, as well as our review of recent country experience in Asia, seems to suggest that none of the available tools to deal with large capital inflows at the individual country level is a panacea, as each involves significant costs or brings about other policy challenges. If policies taken by individual countries are of limited effectiveness, is there any room for collective policy action by a group of countries to deal with large capital inflows? Not surprisingly, relatively little has been said about the potential for collective action, given the presence of general skepticism among economists and policymakers on such approaches and the resulting reluctance of countries to pursue them. However, in the absence of effective national measures to manage excessive capital flows, and given the frequent and compelling need to do something about them, it is time to start thinking outside the box.

Global solutions. On the global level, we have observed over the past several decades that there is cyclicality in global capital flows and that the pattern of capital inflows to specific emerging market economies closely matches that of global capital flows into all emerging and developing countries. One global solution, therefore, is to reduce the cyclicality of global capital flows.

The global initiatives of recent years have focused mainly on transparency as a way to minimize the volatility of capital flows. Behind the transparency initiatives is the idea that better quality information leads to a global allocation of resources that is based more on economic fundamentals, hence leading to a more efficient and stable global flow of capital. While there is no doubt that transparency can minimize surprises in the revelation of unfavorable information and hence sudden reversals, it is difficult to believe that transparency alone can eliminate the broader boom-and-bust cycles of capital flows Metcalfe and Persaud, 2003).

The volatility of global capital flows may well be intrinsic to the way financial markets operate. Proponents of such a view point to evidence suggesting that the incidence of crises has not declined despite the increase in transparency, as evidenced by the US subprime crisis. From this perspective, the role of imperfect and asymmetric information is key in creating herd behavior or “information cascades” that lead to market myopia. “Supply-side” reforms in advanced economy financial markets can be a solution to the problem. Ocampo and Chiappe (2003), for example, proposed that a countercyclical element be included in the regulation of financial intermediation and capital flows (see also Griffith-Jones and Ocampo, 2003). However, such drastic reforms of the regulation of capital flows in source countries are not forthcoming and are unlikely to receive wide support in the near future.

Regional solutions. If no effective global responses are forthcoming, a search for a cooperative solution could begin in our neighborhood. At the regional level, collective action can expand the menu of options available to individual countries. There are three relevant dimensions to regional cooperation in Asia: exchange rate cooperation, financial market supervision and integration, and capacity building on financial supervision and regulation.

Regional exchange rate coordination. If loss of competitiveness is the reason for not allowing its currency to appreciate, a country can cooperate with its competitor neighbors in similar circumstances to take the action simultaneously. Collective currency appreciation is a solution to this dilemma because it allows the economies experiencing large capital inflows to maintain macroeconomic and financial stability without much affecting the international price competitiveness and, hence, the growth prospect of individual countries within Asia (see Kawai, 2008). Such collective appreciation would spread the adjustment costs across Asia, thus minimizing and balancing the costs from the perspective of individual economies.

In order for collective currency appreciation to become a viable policy option, there must be an effective mechanism of intensive policy dialogue and cooperation. The existing policy dialogue processes among the region's finance ministers (such as ASEAN+3)⁵ and central bank governors (such as the Executives' Meeting of East Asia-Pacific Central Banks [EMEAP]) can play a critical role in fostering the establishment of such a mechanism.

Regional financial market surveillance and integration. One of the main factors behind the severity and simultaneity of the Asian financial crisis was the large impact of swings in international investor sentiments and the spread of the contagious effects throughout the region. To mitigate the impact of investor herd behavior and financial contagion, it is critical for the region's policymakers to intensify their monitoring of financial markets and exchange information on a continuous basis. From this perspective, the surveillance and monitoring of regional financial markets is an important area for regional cooperation.

It is high time for the region to introduce institutions that conduct meaningful financial market surveillance and address common issues for financial market deepening and integration. This could be best accomplished by establishing a new, highlevel “Asian Financial Stability Dialogue” on regional financialsector issues (ADB, 2008). This forum would bring together all responsible authorities—including finance ministries, central banks, and financial supervisors and regulators—to address financial market vulnerabilities, regional capital flows, common issues for financial-sector supervision and regulation, and efforts at regional financial integration through greater harmonization of standards and market practices.

Capacity building. The lessons of the Asian crisis reiterated the need for a sound regulatory and supervisory framework. The role of regulation and supervision in such a situation is to promote financial market stability and minimize systemic risk. Regulators and supervisors must therefore be well trained so that they will be prepared to deal with handling increasing financial risks in the markets, including financial contagion. In line with this, regional cooperation on capacity building for financial regulators and supervisors can be enhanced. This would be another important function for the “Asian Financial Stability Dialogue.”

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